DtA-Chair in Entrepreneurial Finance

VENTURE VALUATION
SS 2002

AN INTRODUCTION TO THE VENTURE CAPITAL METHOD

This note provides an introduction to the Venture Capital Method as a way of valuing highrisk long-term investments. Innovative ventures, who make up for the majority of Venture Capital Investments are characterized by negative cash flows and earnings for a significant amount of time, followed by expected rewards of extraordinary size. Valuing these companies at an early stage of their lifecycle bears noticable difficulties, as the vast majority of the firm value lies in the future. Thus, in those cases the saying that valuation is more an imprecise art than a mathematical science holds even more true than usually. Not rarely, due to the major element of judgement remaining and the often questionable validity of underlying data, traditional valuation methods and comparables may simply not work. Dealing with this dilemma, in these situations investors increasingly rely on the Venture Capital Method. This method has proved to be a useful technique to deliver a rough estimate of the current value of such future-oriented, uncertain investments. Therefore, especially in the US, this pragmatic approach, which takes an investors perspective instead of operating from the firms point of view (like for example the DCF method), is widely used among venture capitalists, business angels and other private equity investors. In section 1 the basic method is described. Due to their practical relevance this note covers both popular approaches to the Venture Capital Method. After explaining the steps of the procedure and pointing out the general case, these two approaches are illustrated by computing an actual example. Subsequently the basic proceeding is taken a step further in section 2 by putting dilutive effects into consideration. Again, the method is first explained for the general case and afterwards illustrated by computing the example. This note finishes with a look on some further sophistications like option pools or multiple investors.

This note was prepared by Postdoctoral Fellow Ron Engel at Stanford University as the basis for class discussion. Copyright 2002 by the author. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means electronic, mechanical, photocopying, recording, or otherwise without authors permission. To order copies or request permission to reproduce materials, send an email to ef.sekretariat@wi.tum.de. Version: 5/30/02

Teaching Note: An Introduction to the Venture Capital Method

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1
1.1

The Basic Method

Procedure

(1) The Venture Capital Method follows a very simple pattern. First a terminal value (Vt) of the company is estimated for the time of disinvestment (exit). To do so, most often multiples (primarily comparable companies) are used. Which comparable should be used in any given case depends on factors as the expected financial situation of the company and the industry it operates in. Following the basic Venture Capital Method, this estimation is exclusively based on a success scenario, in which the company fulfills all her and the investors expectations. (2) This terminal value is then converted into a present value ( V0Post ) by applying a comparably high discount rate (r) stipulated by the investor. This is called a post money valuation, which means, that the investment by the investor (I) is already included, i.e. the value of the company one logical second after the initial investment has been made.1 For this conversion two ways of proceeding are common. Some investors apply the concept of internal rates of return (IRR), while others draw upon the net present value framework (NPV). The results are identical. As most students have had more exposure to the NPV framework, which also is a little more intuitive in some regards, the emphasis of the course session will be on this approach. Nevertheless, differences between the two practices are pointed out in this note. (3) The ownership fraction (F) demanded by the investor is determined by the ratio of the amount of his investment (I) and this present firm value. (4) Expressed in terms of shares this fraction has to be set in relation to the number of total shares, which itself is the sum of existing shares (X) and the new shares (Y) to be issued to the investor. The share price (SP) results from dividing the amount of the investment by the number of new shares being issued. 1.2 General Case

For the general case the described steps can be expressed by the following very simple equations. Venture Capital Method applying the NPV-framework
Step 1 Step 2 Estimating terminal value Determining present value eg.: Vt = P/E Ratio * Earnings

V0Post =

Vt (1 + r ) t

Step 3

Calculating demanded ownership fraction

F=

I V
Post 0

Step 4

Obtaining number and price of new shares

Y=X

I F ; SP = 1 F Y

Corresponding to this, the pre money valuation would be V0

Pr e

= V0Post I .

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1.3

Example

To illustrate these steps (and further enhancements of the method) I will draw on the following example throughout this note. Underlying this example is an actual Seed stage investment done by a German investor in 2001. To secure anonymity all names have been replaced and all numbers slightly changed. Imagine a recently founded company Correx (C), which aims to offer software solutions in the field of human resources planning and services billing. At the moment the existing capital is divided equally among the 4 founding entrepreneurs who own 250 Tsd. shares each. The entrepreneurs try to raise external capital and pitch their idea to the early stage venture capitalist Easymoney (E). They state that at the end of Es 4 year investment horizon they expect to have revenues of 17 Mill. per year. To reach their goals and get their company started they need 600 Tsd. . Existing companies, whose business model comes nearest to the one of C, get typically valued with a sales multiple around 1,5. The IT experts of E come to the conclusion that the market and the business model are undoubtedly attractive, but due to the lack of experience within the team and a couple of other reasons this is considered to be very risky business. So a discount rate of 70% per year seems to be appropriate to them. Asking how many shares would E have to demand in this case, the Venture Capital Method provides the following results: Step 1: Estimating terminal value The estimation of the terminal value is done here by a sales multiple, as the company does not expect to be profitable by the end of Es investment horizon. Her value 4 years from now is anticipated to be Vt = 17 Mill. * 1,5 = 25,5 Mill. . Step 2: Determining present value Applying a discount rate of r = 70% = 0,7, E presently values C at V0Post =
3.053.124 Mill. . 25,5 Mill. = (1,7) 4

Step 3: Calculating demanded ownership fraction

The ownership fraction to be demanded by E is F = 600.000 = 0,19652 19,65% . 3.053.124

Step 4: Obtaining number and price of new shares

As every one of the four founding entrepreneurs obtains 250.000 shares, there is a total of X = 250.000*4 = 1.000.000 existing shares. Understanding this, the number of new shares being 0,1965 600.000 Mio. = 244.580 with a share price of SP = = 2,4532 . issued to E is Y = 1 * 0,8035 244.580

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1.4

An alternative approach by applying the concept of IRR

Other than the described approach to the Venture Capital Method, the framing of this technique in the language of IRR is not discounting a future value to the present time but a forward looking way of determining the ownership fraction (and eventually the number of shares) to be demanded by the investor. At this point it is stressed again, that both approaches result in the same answers and figures. Again the general case can be expressed by some very simple equations: Venture Capital Method using the IRR-concept
Step 1 Step 2 Step 3 Estimating terminal value Determining desired future wealth by investor Calculating the therefore needed ownership fraction Obtaining number and price of new shares eg.: Vt = P/E Ratio * Earnings

W = I * (1 + i ) t F= W Vt F I ; SP = 1 F Y I or V0Post = SP * ( X + Y ) F

Step 4

Y=X

Step 5

Determining current valuation

V0Post =

V0Pr e = V0Post I or V0Pr e = SP * X

Using the above example the IRR-oriented approach proceeds as follows:

Step1: Estimating terminal value

The terminal value is estimated the same way as above. V4 = 25,5, Mill. .
Step 2: Determining desired future wealth by investor

Whenever E invests in a company, they will formulate a desired rate of return. This rate of return equals the discount rate applied above. It is usually comparably high due to a number of reasons, which be will discussed in more detail. Assume E is asking for 70% IRR (represented by the variable i). Again C needs an investment of 600.000 . Given this, E would like to attain W = 600.000 * (1 + 0,7) 4 = 5.011.260 by the end of year 4.
Step 3: Calculating the therefore needed ownership fraction

To achieve this wealth by the given valuation at the terminal date, E has to hold 5.011.260 F= = 0,19652 19,65% of C. 25.500.000

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Step 4: Obtaining number and price of new shares

As above, with a total of 1.000.000 existing shares, the number of new shares to be issued to 0,19652 600.000 E is Y = 1 * Mio. = 244.580 with a share price of SP = = 2,4532 . 0,8035 244.580
Step 5: Determining current valuation

Todays valuation can then be determined in more than one way. If 600.000 buy 19.65% of the company, these 19,65% should equal 600.000 . Therefore 100% or the whole company is 600.000 valued at V0Post = = 3.053.124 Mill. . The same result is obtained by multiplying 0.19652 the total number of shares with the share price: V0Post = 2,4532 * (1.000.000 + 244.580). The Pre Money valuation (i.e. the value of the company before Es investment of 600.000 ) consequentely is V0Pr e = 3.053.124 - 600.000 = 2.453.124 (or 2,4532 * 1.000.000).

2
2.1

Valuation assuming future dilution

Problem and procedure

In the example C was valued under the assumption, that it would only receive this one round of financing by E (600.000 ) within the 4 years of Es investment horizon. In reality single financing rounds usually do not take place. Venture Capital usually is staged over a number of rounds depending on the achievement of milestones and the development of capital needs. Financing at later stages commands lower discount rates (and accordingly lower desired rates of return). Thus the staging of capital supply, rather than raising one large lump sum in the first round often creates value for the founders of a venture. As new series of shares will be issued to future investors (actually those investors do not necessarily have to differ from the first round investor) the existing shareholders run the risk of getting diluted. This means, that they might lose part of their ownership due to the issuance of new shares, in other words they would have pay to much in first financing round. The reason for thisis, that without any changes in the investment amount I, not the whole company (without additional increases in capital) is any longer reference object for the ownership fraction but the then larger recapitalized company. Being aware of this, the early stage investor has to demand a higher ownership fraction, to achieve his expected ownership position at the end of his investment horizon (terminal date). However, if more stock is issued to the earlier investor, also the future investors have to receive a higher stake to attain a given ownership fraction. Thus, to determine the necessary current ownership position, the earlier investor has to anticipate the amount of shares that will be issued in the future, but the amount of stock issued in the future partly depends on the amount of shares initially issued in the first round. So, how can this paradox be solved? (1) The starting point is the above derived ownership fraction F, which - without considering dilution represents both, the demanded ownership position after investing and the ownership

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fraction at the terminal date. Thus, in the basic method F = F0Post = Ft holds true. This changes by assuming dilution. Now Ft is expected to be considerably smaller than F0Post . To determine the extent of dilution, the application of the so called Retention Rate (RET) seems to be the best way.2 This retention rate indicates how much of the initially determined ownership fraction will remain after the expected future financing rounds. In other words this rate represents the ratio of the diluted final ownership fraction (Ft) and the current ownership Ft fraction being demanded by the outside investor: RET = Post . As F0Post is sought after and F0 unknown at this stage, this equation per se is not sufficient for determining RET.
But RET can also be thought of as the remaining share of the venture, which will eventually be available to the current investor (and therefore base for his ownership fraction). This can

be expressed by: RET = 1 Fm .

m =1

(2)

Getting
Ft = RET

back
Ft
n

to

the

equation

before

F0Post

can

now

be

calculated

as

F0Post =

1 Fm
m =1

(3) Based on F0Post the following steps match the procedure of section 1. For the several relevant points of time (terminal date of current investor AND every date of capital increase) quantity and price of the shares can be calculated. For our seed investor this can be expressed F0Post I formally by Y * = X and SP * = * . Post Y 1 F0 This step is to be repeated for the different financing rounds, but you should pay attention to inserting the appropriate number of total shares at each time.
2.2 The general case

Adding these steps to the above described basic method, the general case can be summarized as follows.

An alternative way would not draw upon the retention rate but directly upon the rate of dilution. But compare Scherlis/Sahlman (1989), p. 48 about the then arising circularity problem.

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Venture Capital Method (NPV) considering multiple rounds of financing

Step 1 Step 2 Estimating terminal value Determining present value eg.: Vt = P/E Ratio * Earnings

V0Post =

Vt (1 + r ) t

Step 3

Calculating demanded ownership fraction

F=

I V
Post 0

Step 4

(a) Calculating ownership fractions for dilutive (future) investments by pursuing steps 1-4 for those cases. Considering dilution

Post Vtd =

Vt

(1 + r ) t td

F=

I V
Post td

with td as time of dilutive investment

(b) Determining Retention Rate

RET = 1 Fm
m =1

(c) Calculating increased demand of ownership fraction (dilution adjusted) Step 5 Obtaining number and price of new shares

F0Post =

Ft RET

Y* = X

F0Post ; 1 F0Post I SP * = * Y

Keep in mind that depending on the number of future investors and financing rounds you might have to exert step 4(a) as many times as there are future investments, which dilute the existing ownership positions.
2.3 Example

Going back to the example of Correx, let us assume, that ceteris paribus the initial investment is planned to provide enough liquidity for the first two years. After this period of time C expects to be ready for market entry and intends to raise an additional 1,5 Mill. . Let us assume, this money is invested by another VC-company called Laterbird (L). As this time Es Es business concept will be developed further and it will not be considered as a seedinvestment but a start-up- or expansion stage investment, where overall risks are normally considered to be noticeably lower. Consequently, the discount factor (i.e. the desired rate of return) will also be significantly lower in this example 40%.

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Step 1-3 are exactly the same as in section 1.3. Step 4(a): Calculating ownership fractions for dilutive (future) investments

Then in step 5 (a) exactly the same calculations are done from Ls point of view. Starting with the valuation at the end of year 4: V4 = 25,5, Mill. . L would value C in year 2 (the time of 25.500.000 Ls investment) at V 2Post = = 13.010.204 .3 Given the amount of the investment 42 (1 + 0,4) as IL=1.000.000 this investor would demand an ownership fraction of 1.500.000 FL = = 0,11529 11,53%. 13.010.204
Step 4(b): Determining Retention Rate

Knowing that, Es retention rate is RET = 1-0,1153 = 0,8847 = 88,47%. In other words, the existing owners of the firm (the founders and E) would retain only 88,47% of the companys shares altogether.4
Step 4(c): Calculating increased demand of ownership fraction

To compensate for this dilution the increased ownership demand of E at the current point of 0,1965 time is calculated as F0Post = = 0,2221 = 22,21% . Keep in mind, that at the end of year 0,8847 4 E will not hold 22,21% of the company but 22,21% of the remaining 88,47% of the company, which equals 19,65% of the company. In other words by increasing her demanded ownership fraction E would be able to fully compensate the anticipated dilution caused by the financing round in year 2.
Step 5: Obtaining corresponding number and price of new shares

Obtaining the resulting number and price of shares again works like in section 1. Es 0,2221 demanded ownership fraction equals Y * = 1 * Mio. = 285.512 shares with a share price 0,7779 600.000 of SP * = = 2,1015 . 285.512 If you want to determin the number of shares to be issued to L as well, repeat this step, but be sure to insert the correct total number of shares. That is the sum of the founders shares and all other shares, which have been issued to earlier investors. In our case the number of existing shares is 1.000.000 + 285.512 = 1.285.512. The number of shares being issued to L

As said before, the pre money valuation amounts simply this figure subtracted by the amount of the
Pr e

investment. Therefore V2
4

= 13.010.204 1.500.000 = 11.510.204 .

Not coincidently, the value of these shares equals the pre money valuation in year 2 as a pre money valuation measures precisely the value for existing owners of a firm.

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therefore is Y = 1.285.512 .
2.4 Steps beyond

0,1153 1.500.000 167.536 with a share price of SP = 8,95 167.536 1 0,1153

Treatment of option pools

Newly founded start-ups issue shares not only to investors to attain financing but also to provide incentives for their employees. Especially technology-oriented ventures have to use this incentive instrument to a large degree to attract the best talent. The easiest way to account for those option pools is to assume that they are fed from the founders shares. In this case the calculations do not change much. Imagine that in the example given above an option pool of 200.000 shares is established. As the post money valuation is not affected by this, either the amount of shares held by each founder is reduced by the relevant amount of shares, or this amount of shares is issued for this purpose. The first case implies that every founder now holds 200 Tsd. instead of 250 Tsd. shares. Combined with the option pool the entire sum of share still totals 1 Mio. shares. An issuance of 200.000 new shares for the option pool would lead to a total of 1,2 Mio. shares. As the post money valuation (and the pre money valuation) by E would be unaffected, the number of shares to be issued to E will increase by 20% (since 1,2 Mio.=120%*1 Mio.) and the share price decrease by 20%. Expressed in numbers, E invests 600 Tsd. and demands 293.466 shares (without dilution) respectively 342.615 shares (considering dilution) for a share price of 2,0445 (without dilution) or 1,7512 (with dilution). Sometimes option pools are not established before a point of time when the venture is a little further developed. In cases, when this takes place after the first financing round, the increase of capital for the option pool is treated the same way as every issuance of new shares (anticipation of dilution by earlier investors).
Multiple financing rounds

The general formulation of the Venture Capital Method (Section 2.2) already assumes the possibility of several financing rounds. In the case of two or more dilutive issuances of shares one has to proceed backwards from the last anticipated financing round (this investor is the only one, who will not get diluted), calculating the demanded ownership fraction of every investor, considering and compensating the dilution of his stake. Eventually, the demanded ownership fraction of the current investor (in our case E) can be computed.
More than one investor per round

In the real world financing rounds - especially if it is not the first round - are carried out by more than one investor. There are various reasons for such syndicated investments, like risksharing, pooling of value adding expertise, dealflow-considerations, which will not get explored further at this point. For the Venture Capital Method the implications are little. Since

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split pricing is uncommon one can pool syndicated investments and treat investors of each future round as one big investor. For the current round, the same applies. Subsequently, every current investor demands an ownership ratio (expressed in a certain number of shares), which corresponds to his part of the total investment sum.